The Bank of England has slashed the UK base rate to 0.25 per cent in a bid to boost economic demand at a time when coronavirus is causing severe economic uncertainty.
The central bank said the reason for the cut was that the “magnitude of the economic shock” caused by the coronavirus was likely to lead to “economic activity weakening” in the coming months.
Explaining why the central bank believes an interest rate cut is the answer to the present problems, the statement issued by the Bank of England this morning read: “Temporary, but significant, disruptions to supply chains and weaker activity could challenge cash flows and increase demand for short-term credit from households and for working capital from companies.
"Such issues are likely to be most acute for smaller businesses. This economic shock will affect both demand and supply in the economy.”
A supply shock in the economy happens when it becomes more difficult for companies to bring goods to market, this causes inflation, and reduces the rate of economic growth over the long-term.
A demand shock happens when the level of economic activity falls as a result of consumers and companies having less money to spend, or believing they will have less money.
Lower interest rates may help reduce the supply shock by making it easier for companies to borrow, and so get their goods to market.
They may also help to reduce the impact of a demand shock by reducing the cost of debt repayments, leaving more cash for individuals and companies to spend on other things.
Lower interest rates would also be expected to boost the price of assets such as property and shares, because the return available from cash is made less attractive and this may mean investors are tempted to hold less in cash and move into riskier assets.
Alongside the interest rate cut the Bank of England announced measures to make it easier for small and medium sized businesses to access credit.
Karen Ward, chief market strategist for EMEA at JP Morgan Asset Management, said: “Of course the key question is, will rate cuts work to reduce the impact of the Covid-19 virus on the economy? We wouldn’t dismiss entirely the role monetary policy can play.
"Rate cuts and new asset purchase schemes could provide some support to asset prices, as investors are forced to search for yield, and encourage governments to spend given they can finance larger deficits at cheap interest rates.”
The UK chancellor, Rishi Sunak, is to present his first Budget today, and it is likely that he will announced a wave of new borrowing to finance higher government spending. This borrowing will be made cheaper by UK interest rates being lower.
Ms Ward believes the extra spending may prove more effective as a method of dealing with the economic problems caused by the coronavirus than the interest rate cut per se.